The Rule of 78’s sounds like a sort rule that you would come across in a game of cards, but this rule is often used in the loan industry. It is also commonly referred to as the Sum-of-the-digits or figuring prepayment penalties on pre-computed car loans.
What is the Rule of 78’s?
This rule was coined in the beginning of the 20th century and it was a convenient way for lenders to compute charges to borrowers who completely paid off their loans before they were due. While 17 states have banned this method, it can be found in auto loan and installment loan contracts in the remaining states who allow them.
However, the Rule of 78’s in regards to car loans is only utilized with pre-computed car loans. The best way to describe a pre-computed loan is one where interest is calculated before the loan is agreed upon.
The problems with pre-computed loans is that borrowers need to sign a contract that states they agree to pay the full amount of interest that accumulates on the loan. This means that even if the borrower comes across a large sum of money a few days or months after they signed this agreement, they won’t be allowed to pay off the loan in full, unless they also pay the amount of interest owed.
However, lenders persuade borrowers into pre-computed loans by stating they will give the borrower a “rebate” of the interest owed, by enabling them to prepay the loan for a fee.
What lenders do not mention, however, is that the rebate they offer borrowers is not generous when you consider traditional loans, which allow consumers to prepay the loan at anytime they desire with no additional charge.
What is an Auto Loan Supposed to Look Like?
Traditional car loans are calculated with simple interest. When a borrower takes out a loan with simple-interest financing, they can significantly reduce the amount of interest they owe by making more than the required payment each month. This also helps to greatly reduce the amount of principal they owe.
Therefore, when borrowers are interested in purchasing a car, they need to steer clear of the Rule of 78’s pre-computed auto loan. When in doubt, ask the car dealership what kind of loans they offer. If they tell you that the loans they offer are the Rule of 78’s pre-computed car loan, thank them politely and take your business elsewhere.